The Economist: The Federal Reserve System turns 100 this year

By Ray Perryman
Aug. 31, 2013 at 3:31 a.m.

One of the most powerful entities in the world, the U.S. Federal Reserve System (the Fed), turns 100 this year. When the Fed was founded, financial panics were a severe problem, causing bank failures, business bankruptcies and other mayhem.

Without the safety net of a guaranteed source of funds for banks running low on cash, real or rumored shortages of funds at a financial institution could cause massive withdrawals of deposits.

As an unfortunate result, all too often rumor did become reality with banks running out of money and a panic ensuing.

These severe economic disruptions, particularly the Panics of 1893 and 1907, led Congress (after heated debate) to pass the Federal Reserve Act "to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States and for other purposes."

The act was signed into law by President Woodrow Wilson on Dec. 23, 1913, marking the first time the country had a central bank since Andrew Jackson's closing of the Second Bank of the United States in 1836.

The Federal Reserve System is independent in that its decisions are not subject to control by the president, though Congress does have oversight authority. Its seven governors are appointed to 14-year terms to avoid political pressures and assure that appointments span administrations.

In addition to its duties of regulating banks and maintaining the stability of the financial system, the system also provides financial services to depository institutions, the U.S. government and foreign official institutions and is integral to the US payments system. The other important role of the Fed is implementing monetary policy.

Most of us take for granted most of what the Fed does. We expect that when we write or deposit a check or visit an ATM, for example, the right bank accounts will end up with the right amounts of money. However, the monetary policy piece is both more in the news and less well understood.

The stated goal of the Federal Reserve System's monetary policy is to maximize employment, while simultaneously keeping prices stable and long-term interest rates under control. Over time, these two subgoals are aligned in that if inflation or interest rates are high, economic performance (and, thus, the employment level) suffers.

In the short term, however, there can be conflicts. For instance, sometimes (like during the recent recession), policy action to stimulate the economy and boost employment has the potential to contribute to inflation down the road.

The first challenge is to decide which priority takes precedence. Historically, price stability has dominated, with full employment left more to fiscal policy. Given the severity of the recent crisis and the inability of Congress to act quickly and boldly, the Fed has stepped into the breach.

Even when a policy direction is set, implementing is extremely difficult for a number of reasons. First, it's hard to get reliable data in a reasonable amount of time. Second, even given a good estimate of current conditions, it is then essential to project future directions.

As a person who has been forecasting the economy for decades, I can tell you that there is absolutely no way to do so with complete accuracy. Even the best models cannot incorporate or predict things like natural disasters, military uprisings or technological breakthroughs - not to mention the sheer randomness of the things we do know more about.

To further compound the issue, the Fed's policy tools, while powerful, are not exactly direct. (More about how these policy tools work in a future column.) There is also no way to know exactly how the economy will respond to the Fed's actions, though there is every effort to devise econometric models to predict these reactions. To make matters worse, analysts, pundits and others hang on every word of meeting minutes and comments, which could indicate future Fed actions, reacting to every nuance of potential meaning.

In today's information-driven society, even the hint of a change in direction is enough to move markets. One of the most famous examples occurred in 1996, when then-Chairman Alan Greenspan uttered the phrase "irrational exuberance" in a speech at the American Enterprise Institute for Public Policy Research in Washington, D.C.

He was referring to the stock market and posed the question "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?" This occurred before the Internet was a major phenomenon and well before modern social media, but Asian markets began reacting within seconds.

As we go to press, markets are anxiously awaiting the release of minutes from the Fed's July meeting, which may indicate when the current stance on quantitative easing will change. In June, current Fed Chairman Ben Bernanke said that the central bank expects to taper its monthly $85 billion bond buying program this year if certain conditions are met, and, despite the wisdom of this stance, financial markets went apoplectic.

Stock markets around the world are a very visible sign of just how important the timing of policy shifts is, with shares in many countries near six-week lows and emerging market currencies weakening. As I've discussed before, much of this reaction is likely, in fact, overreaction. Nonetheless, a sharp swing in market indices would not be surprising from the slightest nuance.

The Federal Reserve System is an integral component of the world's financial infrastructure. The monetary policy aspect is subject to controversy and impossible to perfect, but it is nonetheless a driving force in the U.S. (and, in fact, the global) economy. There is also some argument that regulations (or a lack thereof) contribute to certain problems such as the recent housing bubble and subsequent crash. However, many important functions are so well-managed that we are hardly aware of them, and a key early mission, eliminating panics and runs on banks, has clearly been accomplished.

Dr. M. Ray Perryman is President and Chief Executive Officer of The Perryman Group (perrymangroup.com). He also serves as Institute Distinguished Professor of Economic Theory and Method at the International Institute for Advanced Studies.